Investing passively, or tracking a benchmark in other words, is not a bad strategy. Warren Buffett (Trades, Portfolio) has endorsed passive investing in the past as well, especially for those who do not study investing or who feel their investing capabilies could not likely beat the overall market.
In the United States, the S&P 500 index is the most widely followed benchmark by investors of every scale and size, and many ETFs track the movement of this index. The ease, affordability and efficiency associated with investing in the S&P 500 index or any of its constituents have led many investors to limit their investment universe to the largest 500 companies in the country, even though there are attractive opportunities beyond these boundaries.
The reasons to look outside
There are many reasons why investors could benefit from monitoring developments in companies that are not part of the S&P 500.
First, the index represents less than 10% of the total number of companies listed in the United States. The Wilshire 5000 index, on the other hand, is the broadest market index available for investors, even though it attracts much less attention than the S&P 500. In his book One Up On Wall Street, Peter Lynch wrote,"Big companies have small moves. Small companies have big moves," and this rule needs to be remembered by investors who are shopping for high growth stocks in an index that houses the 500 largest companies in the country.
Chances are, the best opportunities will be found elsewhere, and this is exactly what has happened this year. The S&P Completion Index is a benchmark that tracks all publicly listed companies in the U.S. except for the ones that are included in the S&P 500. As illustrated below, the Completion Index has outperformed handsomely this year by returning more than double what the S&P 500 has gained so far.
Source: S&P Dow Jones Indices
Second, companies tend to perform poorly in the market after inclusion in the S&P 500 for the first time. The index committee has an onus to pick mature companies for the benchmark, and this is a reasonable explanation behind the observed market performance. According to an article published in Forbes, newly included stocks in the index have performed poorly over the last couple of years. One possible explanation is the high expectations by analysts and investors for such companies, resulting in massive selloffs if earnings are missed.
Third, the index is highly unlikely to include companies representing disruptive business sectors until these business ideas become mainstream. For instance, Tesla, Inc. (TSLA, Financial) stock has gained a staggering 12,000% in the last decade, meaning $10,000 invested in the company 10 years ago would have turned to an eye-popping $1.2 million by now. Tesla was included in the S&P 500 index only on Dec. 21, and the company has gone from a small-scale automobile manufacturer to the leading electric vehicle manufacturer in the world over the last decade.
This is a classic example of why the S&P 500 index might not be the place for growth investors to look for bargains. Innovative health care solutions, connected fitness equipment and clean energy solutions are some of the growing trends to look out for in the coming years, but it would be impossible for an investor to gain exposure to these sectors by investing in the S&P 500 index.
Fourth, the index is biased toward its largest constituents, meaning it is difficult to diversify by selecting stocks that represent the S&P 500. At the end of November, the top 200 companies accounted for over 70% of the U.S. equity market value, and these large players are mostly responsible for the directional movement of the market. Therefore, investing passively will hardly help an investor achieve an acceptable level of diversification.
Where to find growth in 2021
As we move past one of the most eventful years in history for global capital markets, the expectations are high for U.S. markets to deliver stellar returns in the coming year. The volatility, however, is here to stay as the path to economic recovery will be bumpy.
I think this can be transformed into an opportunity. In the 2014 annual letter to Berkshire Hathaway, Inc. (BRK.A, Financial) (BRK.B, Financial) shareholders, Warren Buffett wrote:
"Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors, and CEOs astray."
Highly volatile stock markets, as Buffett believes (and I agree), should not be avoided by investors because such trading conditions often lead to irrational stock prices, and prudent investors stand to benefit from this development. The performance of U.S. markets can be expected to be positive in 2021 because of a few reasons:
- The spread of Covid-19 will likely begin to taper due to vaccine distribution.
- The World Bank projects the U.S. economy to report positive numbers.
- The uncertainty created by the political risks will no longer be a threat in the new year as presidential elections are now over.
- The second fiscal stimulus package is expected to be approved in the coming days.
- The Federal Reserve has pledged to keep interest rates low to support the revival of business activities.
Big tech names and a few financial services companies will thrive under the prevailing conditions, but the best performances might come from lesser-known names representing high growth business sectors. BNP Paribas, for example, believes 2021 will be a year in which small-caps shine. In a research note to clients, BNP Paribas analysts wrote:
"While technology stocks are still likely to be supported, we see the impact of a successful vaccine roll-out as decisive for the economy. This will likely support value stocks, especially small caps, which have been worst hit by the Covid-19 lockdowns."
Due diligence will go a long way in helping investors secure sustainable returns, and the liquidity profile of a company needs to be given attention in valuation models as the U.S. economy is still not out of the waters.
Takeaway
Investing in the S&P 500 is easy and cost-effective, but the idea behind investing in the stock market is to generate alpha returns in the long run, not to select the easiest investment vehicle available. There are many opportunities outside the most-followed index in the world, but some investors remain oblivious to this fact.
In the coming year, small companies that do not have what it takes to be included in the S&P 500 are likely to deliver the best returns, and tactically allocating assets to reflect this expectation can deliver stellar returns to both value and growth investors.
Disclosure: The author does not own any shares mentioned in this article.
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